Can the Average Investor Cash in on the Latest Mergers?

“Merger Mania” is sweeping Wall Street. But what does it mean? And, more importantly, is there an investment opportunity here for you?

The answer in a moment, but first, let’s get a little perspective on why merger activity is heating up, and look at two big deals in the news.

Despite what many doom-and-gloom analysts are saying, corporations are awash with cash, and they are looking for a smart way to reinvest this money. Now, some corporations are using that cash to buy back their stock, while others are hiking up their dividend payments[1]. I’m a big fan of each of these strategies. They benefit the individual investor and my palms itch in anticipation of the impact on earnings and the profits that come from it.

But there’s another very reasonable use for this cash that is becoming very popular right now and is making big splashes in the headlines: mergers and acquisitions. It seems like each day brings a new multibillion-dollar corporate bid, and investors are getting caught up in the mania.

Today, we’re going to take a look at two of the biggest deals making headlines and see if now is the time to jump in or steer clear.

Now, before you let the drama of the headlines get you too excited about any acquisition deal, you have to check the financial health of the two companies. After all, any reasonable consumer wouldn’t make a major purchase without getting his/her fiscal house in order, so why should any company?

So, today I’m going to go over two major corporate bids that still are in the planning phases, and show you how to spot red flags that should keep you from trying to catch the rallies surrounding these stocks.

Kellogg & Proctor & Gamble

First up, Kellogg (NYSE:K[2]) announced it wants to buy[3] Proctor & Gamble‘s (NYSE:PG[4]) Pringles division, in a deal valued at $2.7 billion. Earlier, P&G was in talks with Diamond Foods (NASDAQ:DMND[5]) for a possible Pringles buyout, but that plan fell through when Diamond blew up over accounting restatements[6] and questions about fraud.

If the new merger goes through, Kellogg’s 2012 earnings per share would be reduced by as much as 16 cents, and P&G’s earnings would increase by as much as 50 cents per share. That is a big impact for both companies, but this would be the largest acquisition in the food industry since Nestle (PINK:NSRGY[7]) acquired Kraft‘s (NYSE:KFT[8]) pizza business two years ago.

Kellogg popped 5% yesterday on the news of the acquisition, but looking at Kellogg’s Portfolio Grader report card[9], I’m not overly impressed with its fundamentals. The company’s earnings and sales growth is weak enough as it is, and such a large buyout could disrupt the company’s top and bottom lines in the near term. Also, Kellogg would need to borrow about $2 billion to finance this deal, which is expected to close by summer 2012.

So although adding Pringles to its portfolio would increase Kellogg’s presence in international markets[10], especially in Asia, at this point, I would not recommend purchasing K shares. Wait and see if Pringles really does boost Kellogg’s business. If so, you can certainly add it to your buy list later.

But what about Proctor and Gamble?

If you have shares of PG,[11] hold them, but if not, I would recommend looking elsewhere because despite the short-term earnings boost, I think there are stronger companies with better growth prospects.

Capital One Financial & ING Groep

This week brought news of another major acquisition, this time from the financial sector. On Tuesday, regulators approved Capital OneFinancial‘s (NYSE:COF[12]) $9 billion offer for ING Groep‘s (NYSE:ING[13]) ING Direct USA — an online bank. This acquisition was announced back in June 2011, but federal approval represents a significant step toward closing the deal.

Capital One has been on a buying spree lately, and this newest acquisition would make the bank the fifth-largest lender by U.S. deposits. This deal should close in the next few days, and investors responded by pushing shares of both companies up this week. Again, though, is this a good buying opportunity for either stock?

The simple answer is, I don’t think so. Don’t get caught up in the hype.

Anyone who has met me knows I steer clear of financial stocks, and these two are no exception to the rule. Just take a look at Capital One’s Report Card[14], then glance at ING Groep’s ratings[15]. As you can see, both companies have a long history of earnings misses and have rightly made analysts uncertain about their earnings prospects.

No wonder both stocks have been floundering in “hold” and “sell” territory for much of the past 12 months. Currently, I consider both stocks D-rated sells, so now is not the time to add COF or ING to your portfolio.

When you own a stock involved in a merger or acquisition — or even if your stock has rumors of M&A activity — it can be like winning the lottery. I like a one-day profit of 20% or even 40%, but playing the lottery is not investing. The best way to profit from merger mania is to only buy fundamentally sound companies that would be attractive takeover targets, but aren’t depending on a takeover for survival.

The best way to find companies that fit these criteria is to use my Portfolio Grader tool to screen for the small- and mid-cap companies with the best fundamentals[16]. In particular, you should be looking for companies with strong sales, growing earnings and big cash positions. They are the most likely takeover candidates.

Endnotes:

others are hiking up their dividend payments: http://investorplace.com/2012/02/does-a-dividend-boost-warrent-a-buy-bp-wu-has/